ISDA – to Net or not to Set-off

Decree-law 70/97 of April 3 (the
Portuguese Netting Law)
undoubtedly took the market by
surprise. In 1997, when
international banks were still trying to
impose the ISDA documentation standard
on locals (banks and institutional clients),
Portugal became a netting jurisdiction.
This was ahead of a number of more
financially sophisticated jurisdictions,
including our favourite neighbour Spain.

The original ISDA Netting Opinion for
Portugal never really recovered from the
surprise enactment of the Netting Law,
casting uncertainty as to the extent of its
local enforcement to certain local
counterparties (banks). The solution it
recommended in such cases (the
Automatic Early Termination (AET))
reflected the mistrust of how local courts
would assess the ISDA's documentation
cornerstone – the Single Agreement
concept linked to the close-out netting
mechanism, in case of an early termination
in a bankruptcy scenario.

The conclusions of the ISDA (original)
Netting Opinion were not however shared
by all local law firms assisting derivative
documentation, and who were therefore
ready and willing to issue 'clean' and
'clearer' netting opinions for Portugal.
The two-track understanding of this core
issue was particularly evident when a
different law firm was invited to prepare
and issue the ISDA Collateral Opinion for
Portugal (2001).

Second opinion

In this (second) opinion, the Single
Agreement principle was clearly upheld
and consequently 'netting' was deemed
enforceable in all circumstances. The role
of the Netting Law was deemed to be a
comfortable (credit) relief in the face of
local judges still tempted to re-characterise
the ISDA's Single Agreement/close-out
netting concept as a 'set-off' (since the
latter is precluded by insolvency laws, at
least, as of the insolvency declaration).
In such cases, the Netting Law would
clearly stand-out as an exception to such a
preclusion, enabling netting, even if recharacterised
as a set-off, to be enforceable
against the insolvent estate and the
creditors thereto.

The differences in the ISDA Opinions
for Portugal (Netting and Collateral) were
further tested by Article 119/2 of the
Portuguese Insolvency law, by providing
that any contractual provision granting
one party a right of set-off (compensação)
upon insolvency of the counterparty – or a
right to terminate other than in the terms
provided under the Insolvency Code – be
deemed null and void.

Again, besides interpretative differences
and the ability of the Netting Law to prevail
against subsequent statutes, even of a special
nature, the real issue was again the capacity
of the Portuguese legal system to fully cope
with (and 'digest') all of the consequences of
the ISDA's Single Agreement concept and
accept that the determination of the close-out
amount is carried through 'netting' and not
by 'set-off'.

Once settled, the issue of the ISDA
Opinion's level (Netting and Collateral),
and law firms hopefully consistent
positions on the Netting versus Set-off core
issue, will certainly be paramount to
addressing new legal challenges grounded
on the same question.

The one issue that has the potential to
become the new 'flavor of the month' will
relate to the extension of ISDA Opinions to
entities held by the State (public
companies or EPEs) – which in their actual
format and terms do not. The core issue is
particularly relevant in this area, since the
Portuguese Civil Code expressly precludes
set-off against credits of the Portuguese
State or of other public entities (except if a
law specifically authorises it, as it did
vis-á-vis the Portuguese Republic ISDA
regulated derivative transactions).

Hence, since the Netting Law addresses
insolvency related set-off preclusion (and
not the preclusion of public entities
credits), a 'clean' and clear legal Opinion
will need to be grounded on the core issue
of the ISDA's Single Agreement concept
and to address the epic question – to Net
or not to Set-off – with a legally material
and affirmative answer.